Ups & Downs of Leveraging

"...panic unwinding of margin trading positions led to the 1987 crash on Wall Street..."

"...excess leveraging has led to the creation of a bubble in the market...."

"...SEBI imposes higher volatility margins..."

 

What is leveraging? What is margin trading? How do these exaggerate market movements?

"Give me a place to stand on, and I can move the earth"… Archimedes, the great Greek philosopher, was confident of achieving this because he had realised the power of 'leverage' - the action of a lever. A lever is a simple mechanical device that rests on a pivot and helps lift a heavy load with minimum effort.

 

What is the connection with finance?

During our session on capital structuring, we learnt how companies borrow capital (debt) to enhance return on equity. The expectation of companies is that they would be able to get more returns than their cost of debt, and hence improve the return on equity.

 

How does leveraging work in the securities markets?

Just like companies, security market participants believe that if they can earn higher returns than their cost of borrowing, they will be able to boost their returns on capital. Hence, leveraging in the securities market refers to money borrowed to cover part of the cost of purchase of a security. And in our context, security stands for stocks.

 

Did you say part of the cost?

Yes. Remember that companies start with equity capital for their business before borrowing to leverage that equity capital. Similarly, stock market participants have to bear part of the cost that covers their commitment. In stock market language, the upfront money that the participants pay is called 'margin'. The balance is borrowed at a certain cost.

 

How does it help?

Let us take a simple example. Assume you figured out that Infosys would go up by 15% next week. You have Rs1,10,000 at your disposal. If the closing price of Infosys is Rs11,000, you will be able to buy 10 shares. In case the stock does move up by 15%, you will end up with stock worth Rs1,26,500 (Table 1: Case A).

Now, imagine if somebody offered to finance your purchase on the condition that you pay up 20% of the value as margin and pay him a borrowing cost of 0.25% per week. Taking Rs1,10,000 as your 20% contribution, the lender would be ready to fund you to the tune of Rs4,40,000.

Then, you could actually take a position in the stock worth Rs5,50,000. In other words, you could buy 50 shares of Infosys. Now assume that the stock gained 15%. You sell your shares for Rs6,32,500. After you repay Rs4,40,000, the borrowed money, and the interest of Rs1,100, you would be left with Rs1,91,400. Adjust it for the capital that you placed as margin money. Lo! Behold! You have a profit of Rs81,400 or a return of 74% in one week! Look at what leveraging can do for you. (Table 1: Case B).

 

	15% Price Rise		15% Price Fall
	Case A	Case B	Case A	Case B
Capital	110000	110000	110000	110000
Borrowing	0	440000	0	440000
Infosys
Purchase Value	110000	550000	110000	550000
Realised Value	126500	632500	93500	467500
Cost of Borrowing	0	1100	0	1100
Profit	16500	81400	-16500	-83600
RoI (%)	15.0	74.0	-15.0	-76.0

What if the stock falls?

A good question indeed. Let us rework the profits in the event the price falls by 15% instead of going up 15% in the period under review. The 50 shares of Infosys will be worth Rs4,67,500. After repaying Rs4,41,100 to the lender, you would be left with Rs26,500. In other words, a loss of Rs83,500 or minus 76% in one week! It can almost wipe your entire capital. If you had not leveraged, you would have lost only 15%. (Table 1)

 

So, how does the lender protect himself?

The lender runs a big risk of the borrower defaulting. Hence, he normally increases the 'margin' requirement to compensate for the decline in market prices in order to protect his capital.

 

A double-edged sword

Leveraging is a double-edged sword. You can expect phenomenal returns despite taking on a fixed cost if your instinct is right and the market plays itself out according to your expectations. But if it does not, the results could be catastrophic.

In the next part, we will relate leveraging and margin trading to the carryforward system that is prevalent on the Bombay Stock Exchange (BSE) - the badla system. We will discover how the carryforward system handles 'marked to market' margins. We will then try to understand how leveraging impacts our market. We will also try to cover how leveraging creates market bubbles, and how traders who stay leveraged lose out in the long run.